Stockholm (HedgeNordic) – Volatility is a feature of most asset classes, as it is for cryptocurrencies. While most investors fear volatility, with the conventional view equating price fluctuations with risk, there are ways to profit from volatility. One such way is volatility harvesting through the systematic rebalancing of a portfolio.

Volatility harvesting involves a continuous process of buying low and selling high, and portfolio managers can harvest more returns through rebalancing as volatility increases. Due to high volatility, cryptocurrency markets are replete with opportunities to harvest volatility. Swedish digital assets investment firm Hilbert has been using an algorithmic model dubbed Caerus to capture alpha-generating rebalancing opportunities within the crypto space since 2017.

To illustrate the concept of volatility harvesting, picture a portfolio worth $200 that is equally allocated between Bitcoin and cash. Should the price of Bitcoin drop from a starting value of $30,000 to $15,000, the portfolio would now be worth $150 with $50 in Bitcoin and $100 in cash. In the next step, the portfolio is again equally weighted between Bitcoin and cash, with this rebalancing process requiring the use of cash to buy $25 worth of Bitcoin to arrive at a portfolio of $75 in Bitcoin and $75 in cash. If Bitcoin appreciates to $30,000, the entire portfolio would now be worth $225 instead of $200 for a buy-and-hold approach.

“The good thing about volatility harvesting is that it can work in upward trending markets, in sideways trending markets, but also in downwards trending markets exhibiting volatility,” explains Richard Murray, the CEO of Hilbert Capital. This year is an example of volatility harvesting outperforming a buy-and-hold approach. “Cryptocurrency markets clearly have been in a downward drift in 2022, so market directionality has been a drag on performance. Volatility harvesting has offset some of that drag.”

“The good thing about volatility harvesting is that it can work in upward trending markets, in sideways trending markets, but also in downwards trending markets exhibiting volatility.”

The best environment for a volatility harvesting strategy, on an absolute basis, is an upward trending and volatile market. “The constant rebalancing, buying low and selling high, adds additional returns both in an upward trending and range-bound market environment,” reiterates Murray. A volatility harvesting strategy, however, still remains a directional trade by providing exposure to the appreciation of cryptocurrency markets – in addition to taking advantage of price volatility through algorithmic trading.

Hilber Capital’s first fund, Hilbert Digital Asset Fund, has been entirely relying on the Caerus volatility harvesting strategy since launching in January 2019. “The fund offers exposure to the broader crypto asset class with an additional contribution from volatility trading,” explains Murray. The fund has “a mandate to be 100 percent risk-on at all times,” according to the CEO of Hilbert Capital. Despite outperforming on a relative basis, by design, the return profile of Hilbert Digital Asset Fund is volatile and can experience drawdowns along with the broader market.

Lower Risk Exposure to Crypto

In response to increasing demand for cryptocurrencies from traditionally more risk-averse institutional investors, Hilbert Capital has launched a new investment product offering lower-risk exposure to the crypto market using the same Caerus volatility harvesting strategy. “A full risk-on volatility harvesting strategy goes up and down with the market despite adding a big chunk of trading alpha on top, so we asked the question of how to reconstruct the core trading approach to offer something that is more conservative,” reveals Murray.

“Hilbert Digital Asset Fund and Hilbert V1 Fund have common DNA in Caerus.”

The solution was Hilbert VI, which also uses the Caerus algorithmic trading strategy to build a volatility trading portfolio sized to limit the maximum drawdown to ten percent per year. “Hilbert Digital Asset Fund and Hilbert V1 Fund have common DNA in Caerus,” says Murray. “While Hilbert Digital Asset Fund is designed to be at 100 percent risk-on at all times, Hilbert V1 Fund has limited crypto-market directional exposure in the range of 0.1-0.15,” he elaborates. “V1 is by design more conservative with the goal of limiting the maximum drawdown to ten percent, and we size the volatility harvesting strategy according to that constraint.” Since its inception on the 1st of May 2022, Hilbert V1 has produced a negative return of 4.3 percent, compared to a loss of about 60 percent for the broad cryptocurrency market.

“While Hilbert Digital Asset Fund is designed to be at 100 percent risk-on at all times, Hilbert V1 Fund has limited crypto-market directional exposure in the range of 0.1-0.15.”

Hilbert V1 Fund allocates only a portion of capital under management to the Caerus volatility harvesting strategy to maintain its pre-specified risk-return profile, leaving the fund with ample liquidity. The unused liquidity is used to execute more opportunistic trades in the still nascent cryptocurrency universe. “The core volatility harvesting strategy gives us all the risk we want, all the return we need, but we then use some of the liquidity outside of that to take advantage of opportunities that come and go,” summarizes Murray.

Opportunities That Come and Go

The Hilbert team has two criteria for allocating capital to opportunistic trades. “First, the investment opportunity should not bring in additional drawdown risk, and second, it should provide a good level of incremental return,” explains Murray. One such opportunistic trade was the funding rate trade, which involved being long Bitcoin and short perpetual futures, according to Murray. Bitcoin perpetual contracts, which have no expiration date, have offered carry arbitrage opportunities for investors looking to exploit inefficiencies between the spot and futures markets. During a bullish stretch, a carry strategy that uses a long position in the spot market and a short position in futures can generate a nearly risk-free return. With markets more bearish in recent months, such carry opportunities have diminished significantly.

“It was a very attractive trade, but this year the funding rates have been flat or negative, so we have not used it,” says Murray. “The funding rate trade tends to work better in “risk-on” market periods when there are higher volumes of retails investors using futures to gain leverage,” he elaborates. “A conservative return expectation from these limited-drawdown trades is 5-10 percent per year, but there will be periods when little or no return is possible, given our criteria,” emphasizes Murray.

“…what you might marginally gain in incremental additional returns is not a good trade-off with the new execution risk that you bring in.”

The fully-systematized Caerus algorithm assesses trade opportunities every 30 seconds across 1800 possible cryptocurrency combinations. The more opportunistic trades, however, are exploited on a discretionary basis. “Our team has done a lot of research in terms of developing an algorithm that systematically trades carry opportunities,” says Murray. However, the conclusion out of the research has been that “what you might marginally gain in incremental additional returns is not a good trade-off with the new execution risk that you bring in,” he emphasizes. “So we don’t take that trade-off.”

Instead, the Hilbert team seeks to quantify every part of the decision-making process. “We are a quantitative investment group and we quantify everything,” says Murray, including the range of opportunities that can provide carry, the level of carry, the consistency of carry, the liquidity and counterparty risk, among others. “We quantify everything, but ultimately the team is making the choice of which opportunity to allocate to.”

While these opportunistic trades come and go, Hilbert’s volatility harvesting strategy is repeatable and scalable regardless of market conditions. It is not a “trade” or an “opportunity” or an “indicator,” according to Murray. “In 100 years’ time, if markets are 100 percent efficient given full information and we get to a state where no mispricings or indicators exist, Hilbert’s volatility trading approach will be the only way to generate excess returns over a buy-and-hold portfolio,” he concludes. “It’s just math.”

This article features in HedgeNordic’s “Systematic Strategies” publication.